[Marxism] P/E ratio
lnp3 at panix.com
Wed Aug 15 13:05:09 MDT 2007
NY Times, August 15, 2007
Remembering a Classic Investing Theory
By DAVID LEONHARDT
More than 70 years ago, two Columbia professors named Benjamin Graham
and David L. Dodd came up with a simple investing idea that remains more
influential than perhaps any other. In the wake of the stock market
crash in 1929, they urged investors to focus on hard facts — like a
company’s past earnings and the value of its assets — rather than trying
to guess what the future would bring. A company with strong profits and
a relatively low stock price was probably undervalued, they said.
Their classic 1934 textbook, “Security Analysis,” became the bible for
what is now known as value investing. Warren E. Buffett took Mr.
Graham’s course at Columbia Business School in the 1950s and, after
working briefly for Mr. Graham’s investment firm, set out on his own to
put the theories into practice. Mr. Buffett’s billions are just one part
of the professors’ giant legacy.
Yet somehow, one of their big ideas about how to analyze stock prices
has been almost entirely forgotten. The idea essentially reminds
investors to focus on long-term trends and not to get caught up in the
moment. Unfortunately, when you apply it to today’s stock market, you
get even more nervous about what’s going on.
Most Wall Street analysts, of course, say there is nothing to be worried
about, at least not beyond the mortgage market. In an effort to calm
investors after the recent volatility, analysts have been arguing that
stocks are not very expensive right now. The basis for this argument is
the standard measure of the market: the price-to-earnings ratio.
It sounds like just the sort of thing the professors would have loved.
In its most common form, the ratio is equal to a company’s stock price
divided by its earnings per share over the last 12 months. You can skip
the math, though, and simply remember that a P/E ratio tells you how
much a stock costs relative to a company’s performance. The higher the
ratio, the more expensive the stock is — and the stronger the argument
that it won’t do very well going forward.
Right now, the stocks in the Standard & Poor’s 500-stock index have an
average P/E ratio of about 16.5, which by historical standards is quite
normal. Since World War II, the average P/E ratio has been 16.1. During
the bubbles of the 1920s and the 1990s, on the other hand, the ratio
shot above 40. The core of Wall Street’s reassuring message, then, is
that even if the mortgage mess leads to a full-blown credit squeeze, the
damage will not last long because stocks don’t have far to fall.
To Mr. Graham and Mr. Dodd, the P/E ratio was indeed a crucial measure,
but they would have had a problem with the way that the number is
calculated today. Besides advising investors to focus on the past, the
two men also cautioned against putting too much emphasis on the recent
past. They realized that a few months, or even a year, of financial
information could be deeply misleading. It could say more about what the
economy happened to be doing at any one moment than about a company’s
So they argued that P/E ratios should not be based on only one year’s
worth of earnings. It is much better, they wrote in “Security Analysis,”
to look at profits for “not less than five years, preferably seven or
This advice has been largely lost to history. For one thing, collecting
a decade’s worth of earnings data can be time consuming. It also seems a
little strange to look so far into the past when your goal is to predict
But at least two economists have remembered the advice. For years, John
Y. Campbell and Robert J. Shiller have been calculating long-term P/E
ratios. When they were invited to a make a presentation to Alan
Greenspan in 1996, they used the statistic to argue that stocks were
badly overvalued. A few days later, Mr. Greenspan touched off a brief
worldwide sell-off by wondering aloud whether “irrational exuberance”
was infecting the markets. In 2000, not long before the market began its
real swoon, Mr. Shiller published a book that used Mr. Greenspan’s
phrase as its title.
Today, the Graham-Dodd approach produces a very different picture from
the one that Wall Street has been offering. Based on average profits
over the last 10 years, the P/E ratio has been hovering around 27
recently. That’s higher than it has been at any other point over the
last 130 years, save the great bubbles of the 1920s and the 1990s. The
stock run-up of the 1990s was so big, in other words, that the market
may still not have fully worked it off.
Now, this one statistic does not mean that a bear market is inevitable.
But it does offer a good framework for thinking about stocks.
Over the last few years, corporate profits have soared. Economies around
the world have been growing, new technologies have made companies more
efficient and for a variety of reasons — globalization and automation
chief among them — workers have not been able to demand big pay
increases. In just three years, from 2003 to 2006, inflation-adjusted
corporate profits jumped more than 30 percent, according to the Commerce
Department. This profit boom has allowed standard, one-year P/E ratios
to remain fairly low.
Going forward, one possibility is that the boom will continue. In this
case, the Graham-Dodd P/E ratio doesn’t really matter. It is capturing a
reality that no longer exists, and stocks could do well over the next
The other possibility is that the boom will prove fleeting. Perhaps the
recent productivity gains will peter out (as some measures suggest is
already happening). Or perhaps the world’s major economies will slump in
the next few years. If something along these lines happens, stocks may
suddenly start to look very expensive.
In the long term, the stock market will almost certainly continue to be
a good investment. But the next few years do seem to depend on a more
rickety foundation than Wall Street’s soothing words suggest. Many
investors are banking on the idea that the economy has entered a new era
of rapid profit growth, and investments that depend on the words “new
era” don’t usually do so well.
That makes for one more risk in a market that is relearning the meaning
of the word.
E-mail: leonhardt at nytimes.com
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